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Nelson v. Emerson, C.A. No. 2937-VCS (Del. Ch. May 6, 2008) (V.C. Strine)

May 6, 2008

In this decision, the Court of Chancery held that claims for breach of fiduciary duty for excessive compensation and the decision to file for bankruptcy are properly dismissed under the doctrine of collateral estoppel where the plaintiff had raised such claims and received final judgment in a Bankruptcy Court case.  The plaintiff, Nelson, was the sole creditor of Repository Technologies, Inc. (“Repository”) and a member of the board of directors. After Repository failed to make interest payments for almost two years on a debt owed to Nelson, he resigned from the board and threatened to claim an event of default if all outstanding interest was not paid within 15 days.  In response, Repository filed a Chapter 11 petition in the United States Bankruptcy Court and sought to recharacterize the debt owed to Nelson as equity.  Nelson sought dismissal alleging that Repository had been mismanaged by paying inflated compensation to its officers, the defendants, and that the filing was done in bad faith to frustrate Nelson’s rights. After a full trial, the dismissal was granted because Repository could not reorganize successfully in light of the Bankruptcy Court’s decision to recharacterize only a small portion of the line of credit as equity.  In its decision, the Bankruptcy Court expressly stated that Nelson failed to establish any mismanagement of Repository or any bad faith in filing the bankruptcy case and petition.  Nelson appealed to the District Court to strike the determination that the filing was not in bad faith as unessential dicta, however, the District Court rejected this argument. Subsequently, Nelson acquired all of Repository’s assets, including all of its claims, from the receiver appointed by the Bankruptcy Court. Nelson then filed suit in the Delaware Court of Chancery on behalf of Repository alleging that the husband and wife who were officers, directors, and majority shareholders of Repository (the “Emersons”), breached their fiduciary duties to Repository by paying excessive compensation to themselves while the company was insolvent and by filing for bankruptcy.  The Emersons filed a motion to dismiss asserting that the claims were barred by collateral estoppel and failed to state a claim upon which relief could be granted.  The Court found that two elements of collateral estoppel were disputed; whether the determination was essential to the judgment and whether the claims present the same issue. The Court agreed with the District Court that the finding of the lack of bad faith was essential to the judgment of the Bankruptcy Court and that the issue had to be resolved in the judgment because Nelson relied upon such an argument in seeking relief.  Although the excessive compensation claim was not addressed by the District Court, the Vice Chancellor relied upon the same reasoning and refused to allow Nelson to argue that the portion of the Bankruptcy Court opinion addressing the argument he had raised in support of his motion was mere dicta. Therefore, the resolution of both claims was deemed essential to the Bankruptcy Court judgment. Nelson argued that this was a different issue because a different legal standard applied to fiduciary duty claims.  The Court relied upon the prior factual finding and determined there would be no different result under Delaware fiduciary law. Here, the Court noted that a board may pursue any strategy designed to maximize shareholder value if it is done in good faith and the Bankruptcy Court had already found this to be the case. Thus, a strategy of filing bankruptcy to benefit shareholders is not a breach of a director’s fiduciary duties and is protected as business judgment if it is not engaged in frivolously.  Finally, in dicta, the Court addressed the motion to dismiss for failure to state a claim. The Court noted that to withstand this motion the complaint must plead a viable duty of loyalty claim because Repository’s certificate of incorporation included a Section 102(b)(7) exculpatory provision, which eliminated the personal liability of directors for monetary damages for breaches of the fiduciary duty of care.  As stated previously, the Court determined that a director does not commit a breach of fiduciary duty by filing a non-frivolous claim to recharacterize some debt as equity in good faith to protect the interests of the shareholders. With respect to the excessive compensation claim, the Court noted that the complaint was bereft of key facts, including who approved the compensation or even the amount of the compensation and consequently would also dismiss this claim.

The full opinion is available here